I focus on the strategic, economic and business implications of defense spending as the Chief Operating Officer of the non-profit Lexington Institute and Chief Executive Officer of Source Associates. Prior to holding my present positions, I was Deputy Director of the Security Studies Program at Georgetown University and taught graduate-level courses in strategy, technology and media affairs at Georgetown. I have also taught at Harvard University's Kennedy School of Government. I hold doctoral and masters degrees in government from Georgetown University and a bachelor of science degree in political science from Northeastern University. Disclosure: The Lexington Institute receives funding from many of the nation’s leading defense contractors, including Boeing, Lockheed Martin, Raytheon and United Technologies.

Defense Contractors Are Going To Go For The Civilian Market

Bell helicopter maker Textron is a poster boy for the benefits of diversification. Image via Wikipedia

The U.S. defense industry is facing greater uncertainty in its core military markets than at any time since the Cold War ended, and maybe since the industry’s birth in the 1950s. As a result, even though most of the big business moves in the sector this year have been about divestiture and “deconglomeration,” the dominant trend going forward will be diversification.

By diversification, I mean generating more revenue outside the sector’s traditional markets — outside defense, outside government, outside America. This isn’t really what company executives and institutional investors want the industry to do, but the logic of reducing dependence on an increasingly cash-strapped and demanding military customer is inescapable.

I reported last week on how onerous contract terms have become for military suppliers under the new business approach embraced by the Obama Administration. It turns out Democratic political appointees in the Pentagon don’t understand how markets work any better than their brethren at civil agencies. But that is just the tip of the iceberg in terms of the challenges military contractors face.

The larger problem is that all of the main drivers of military demand — threats, politics, and the economy — are signaling tough times ahead for the defense sector. With regard to threats, the recent dangers are receding and there is nothing resembling the Red Army out there to stimulate western demand for weapons. With regard to politics, a Republican victory next year would be good news for arms makers, but that is not assured and the industry has six quarters of results to get through before a new Republican government could start reordering federal priorities.

And then there is the economy, the ultimate foundation of America’s global military posture that previous generations of defense executives thought they could always count on. When it comes to the economy, the defense industry loses either way. If it strengthens, investors rotate out of defense stocks. If it weakens, the fiscal pressures driving weapons cuts grow worse.

So defense executives need a new paradigm for how they deploy capital. They’ve already implemented the standard playbook of tactics for defense downturns, such as cutting costs and divesting underperforming units, but those palliatives will only work for so long before softening demand takes a toll on results. Some of their favorite moves, liking “mining” backlogs for improved terms, are unlikely to work at all with the current crew at the Pentagon. Policymakers are more interested in getting bargains than helping industry make profits.

And the big strategic moves that saved companies during the last downturn aren’t feasible this time, because the top-tier of the industry is now so concentrated. With only two or three producers of most major weapons types still in the business, the Pentagon has stated emphatically it won’t permit new combinations that give suppliers monopoly-like pricing power. Some sizable mergers might be permitted in overcrowded market segments like military electronics or IT, but sector consolidation isn’t going to save this generation of defense executives.

Not that they’re desperate today. Most of the big defense companies are sitting on piles of cash built up during the flush years, and industry tax rates are relatively low given all the opportunities policymakers have handed the sector for writing off, writing down, or otherwise minimizing Pentagon mistakes. But they can’t sit on the cash forever without investors starting to make noises, and something needs to be done to prevent an erosion of margins as contract terms tighten.

So diversification out of defense is one of the few paths forward available to military contractors. The reason some company executives shy away from diversifying is because they’ve been told by generations of investors that the biggest selling point for defense stocks is their “counter-cyclical” behavior, meaning they don’t trade in tandem with the commercial business cycle. Also, there is a widespread belief that the skills companies have developed in dealing with a monopsonistic federal customer aren’t transferable to the less ordered world of free markets.

However, there are already examples of defense contractors like General Dynamics that have thrived while having a foot in both worlds (GD owns bizjet giant Gulfstream), and investors have become worried enough about where military demand is headed so that they no longer reflexively criticize any move that sector players make out of defense. It’s true that multi-industry companies are harder to analyze than pure defense plays like Raytheon, but the information revolution has made even Raytheon a pretty complicated story.

Early signs are that defense companies will try to expand into areas that are adjacent to their core markets, or exhibit similar regulatory features. For instance, General Dynamics and Lockheed Martin are both focusing business development in their information services units on healthcare support and cyber-security, markets that are strongly influenced by federal policies but where there is extensive sales potential beyond traditional military customers. GD bought healthcare IT provider Vangent from Veritas Capital for $960 million in September, and Lockheed has established a fast-growing cyber-security business with companies that operate power grids.

The recent United Technologies move to acquire Goodrich is a very different kind of transaction following the same basic logic. UTX’s aerospace units were already broadly diversified across military, civil and commercial markets, and Goodrich will continue the pattern of leveraging skills that have allowed the company to dominate military rotorcraft and engines markets into non-military areas. Unlike rival Connecticut conglomerate General Electric, United Technologies maintained an extensive presence in the military marketplace after the Cold War ended, and is continuing on that path by purchasing Goodrich even as it grows civil and commercial aerospace revenues.

The only other first-tier player in the defense sector today that enjoys UTX’s broad exposure to commercial markets, both at home and abroad, is Boeing. Chicago-based Boeing will maintain a major presence in military markets, but it has been repeatedly disappointed by its defense customer in recent years, losing hundreds of billions of dollars in potential business. So it is no surprise that most of its future investment will be in commercial-transport development, and that a string of top defense executives have been shifted to the commercial side of the house.

There must be times when executives at Lockheed Martin and Northrop Grumman wish they had the same options as Boeing and United Technologies, given the frequently capricious behavior of their military customer (both are currently battling unexpected Pentagon moves to cut back or kill key weapons programs). As frustrations mount with the tenor of government-industry relations, almost all of the big defense contractors will probably move to reduce their military exposure. Even BAE Systems, the sprawling British defense conglomerate that typically gets along better with the Pentagon than its U.S. counterparts, decided recently not to sell a commercial aerospace unit that was generating strong results despite its apparent mismatch with other company lines.

A good model of where the defense sector may be headed is Providence, Rhode Island-based Textron. Textron was one of the high-flying conglomerates back when such enterprises were considered fashionable in the 1960s, and despite repeated makeovers it remains committed to its multi-industry character. Diversity has served Textron well in recent years, enabling the company to shepherd each of its major business units through rough patches to a point where they could resume steady profitability — the kind of feat that a pure-play military contractor might not be able to pull off in a prolonged defense downturn.

What makes Textron interesting in the current environment is that it has managed to maintain its role as a supplier of unique military equipment to all three military departments while having a major presence in commercial markets such as automotive, recreation and business jets. Those commercial markets are likely to offer more favorable conditions in the years ahead than the military marketplace, and yet the products Textron sells to the Pentagon would be hard for the joint force to do without. It also generates 36 percent of revenues overseas, which is a much higher portion of foreign sales than most military contractors can claim. With all of the uncertainties that defense companies face, Textron’s multi-industry model must be looking more attractive to executives across the sector.

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